Factors close to home dictate 'fair' oil price

For the first time in almost a decade, Saudi Arabia, the world's oil superpower, has named its price. In an interview in a Kuwaiti newspaper published on the day of Opec's emergency meeting last Saturday, King Abdullah said $75 a barrel was a "fair price" for oil. Set against this summer's high of $147 a barrel, the target might seem modest. But compared with the current price of $55, not to mention a historical average closer to $40, it begins to look rather optimistic from the king's point of view.

The last time the largest oil exporters set a figure was in 2000, after a crash which took prices as low as $10 a barrel, when Opec pegged its aspirations to a range of $22-$28 a barrel. This target was quietly dropped as prices took off in the middle of the decade. The king did not explain what gave rise to the new estimate, nor indeed did he go into the many factors that must inform any assessment of fair value for the world's most strategic commodity.

It goes without saying that on this price hangs a major part of the global economy. The price of oil not only determines the cost of transport and power for industry worldwide, it is also a major factor determining the pace at which the planet moves to carbon-free energy sources, and thus the rate at which our globe warms up. However, my suspicion is that the king's criteria for what constitutes a "fair price" lie closer to home. While Saudi Arabia produces oil at one of the lowest costs in the world, probably below $5 a barrel, its ballooning budget is largely reliant on this money. So after accounting for its spending needs, Saudi Arabia's fiscal break-even point is closer to $50, or maybe even $70 if those impressive-looking economic cities on the Red Sea coast are to be built.

So when the king talks about a "fair price", what he is referring to is a price which keeps afloat the Saudi treasury, not the state oil company. Perhaps he also saw in the collapse of the western banking system an opportunity to return to the days before futures markets, when crude oil prices were set on a monthly basis in the capitals of the Gulf. He would be forgiven for being not overly impressed with the performance of these markets, which have greatly exacerbated the natural boom and bust cycles of the industry. Now, with a sharp slowdown in the global economy looming, analysts wonder whether the rest of the world is prepared to subsidise the Saudi budget by paying such a premium.

When the world economy was surging ahead, credit was loose and demand for every imaginable commodity was soaring, there seemed no limit to the price for crude as it broke into triple digits at the turn of this year. Companies launched projects to eek out barrels hiding deep below the oceans at a cost of $60 per barrel and more. Billions of dollars were committed to renewable energy projects such as biofuel that would only pay their way at $70 per barrel.

Just four months ago, "peak oil" theorists were postulating that global oil production had already peaked and could be heading for an imminent collapse, fuelling talk of a $200 barrel. But now that the world economy faces the sharpest correction in at least a generation, pundits are no longer looking at peak supply, but peak demand for oil. Demand has turned out to be much more elastic to oil prices than previously thought.

And on the supply side, many of those high cost projects have gone beyond the point of no return. This all points to an oil supply overhang and price slump. The argument supporting a $75 barrel was based partly on the rising costs of developing new oilfields, from manpower, to steel and concrete. Now these markets have imploded. With contracts being cancelled daily, the big engineering companies are about to start to cannibalize themselves for new business.

So perhaps it was no great surprise to hear my old trading buddy in Dubai, Omar Najia, wasn't giving the king much of a hearing. "I thought the market would drop like a stone after that," he said, adding that he put in some short positions on the futures market as soon as he read the king's interview. "The market is oversupplied and it is getting further away from Opec," he said, adding that he would not be surprised to see prices down at $40 by the time Opec meets in Algeria in a fortnight. "$75 is way too expensive." [e-mail]